Answer the following statements true (T) or false (F)

Question

1. Financial projections are usually very precise and correspond almost identically to reality.
2. Financial projections are built around sales in USD.
3. Linear trends are most useful.
4. For startup firms, projections over long time horizons are rarely supported by either historic data or by methodologies that have good predictive power.
5. When dealing with expenses, direct costs are not projected in the same manner as revenue.

Answer 1

1.False – Making financial projections is as much art as a science. It is an activity that has both ideal and practical aspects.
2.False – The most common mistake made in making or conceptualizing projections is to initially project sales in currency (dollars or any other) instead of units sold and their selling price. This is true for both manufacturing and service companies. Every firm sells a unit of something, whether it is a unit of manufactured product, a unit of time to use something (like an office or a piece of equipment), or a unit of time in which a service is provided (like an hour with an attorney or an accountant). It must be emphasized that projections that are done in dollar units instead of product unit are next to worthless. Only with product units does the analyst have the flexibility to vary both units sold and price per unit to produce projections that are flexible and robust.
3.True – These types of projections produce a sense of direction in unit sales as well as an expression of the gross impact of year-to-year or period-to-period changes. There are basically two ways to produce a linear projection:
• Applying an appropriate periodic growth rate equally through a 12-month period, thus producing a trended projection resulting in a desired annual unit sales projection (after which the trend may continue should the analyst desire).
• Using a linear regression methodology to produce a trended projection of unit sales for the desired period.
4.True – Due to the lack of data and an imprecise understanding of the firm’s operating characteristics. For a startup firm, 3 to 5 years is a usual time horizon over which to project results, with the last 2 years being very inaccurate.
5.True – Direct costs are a function of the number of units sold, not some other function. This means that the prices of the input elements to the production process should be projected, but the total expense for any given element of production will be a function of the firm’s unit sales and not a function of some extraneous relationship. Usually the method used to project these costs is either pro forma or input/output. The projection for the firm’s expenses should respond to the day-to-day work flow of the firm.